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Making the grade

the strategist

Ratings agencies Moody's and S&P dominate the market and are seen as too subjective by some

The stone in the shoe of the global bond market these days is when and if General Motors Corp. and Ford Motor Co. will lose investment-grade ratings at Moody's Investors Service and Standard & Poor's. The fate of about $375bn worth of debt hangs in the balance.

Rating companies have the power of life and death over the borrowers whose debt-paying abilities they assess. Their importance is growing as regulators enshrine credit ratings in accounting and investment rules, and as the global capital markets depose banks as the primary source of lending.

In The New Masters of Capital: American Bond Rating Agencies and the Politics of Creditworthiness (Cornell University Press, 186 pages), Timothy J. Sinclair argues that there's a strong subjective element in how rating companies arrive at their conclusions, and that their perceived authority imposes a single set of business-practice standards globally.

"You could argue that by institutionalizing rating agencies, Anglo-American capitalism risks losing that wonderful capacity for creative destruction," Sinclair said in a telephone interview.

Their power is a kind of confidence trick. Ratings only matter if you and I both agree that they do. Moreover, Moody's and S&P have pulled off the neat trick of appearing to be independent, impartial arbiters of creditworthiness, when they're nothing of the sort.

"People view them as important and act on the basis of that understanding - even if it is impossible for analysts to actually isolate the specific benefits the agencies generate for these market actors," writes Sinclair, who teaches international political economy at the University of Warwick in England.

Moody's and S&P, who dominate the world of credit ratings and "pass judgment" on about $30 trillion of securities, are replacing banks as the "gatekeepers" of who gets to borrow and who doesn't, Sinclair argues.

Moody's and S&P have a vested interest in promoting their work as independent and uncoloured by subjectivity. Sinclair argues that the existence of split ratings - where one company rates a borrower higher or lower than its peer - shows that there's more to assessing creditworthiness than filling out a spreadsheet and cranking the handle.

"By not making it clear that their decisions are judgments, they foster the popular myth that rating actions reflect simply the facts revealed by economic and financial analysis," he says.

Sinclair goes on to argue that assigning a grade is "highly indeterminate, qualitative, and judgment laden.

Sinclair says if investors had a better understanding of how ratings work, it would "perhaps lead to a more skeptical use of rating information."

He has something in common with other critics of the current ratings duopoly, though, including myself: He hasn't found anything to replace it with. Until someone comes up with a new way to determine creditworthiness, we're stuck with the current, flawed system.